Innovation, research and the UK’s productivity crisis

The productivity puzzle comes back to slowing innovation, which means we need to consolidate the country’s excellent research base.

The UK is in the midst of an unprecedented peacetime slowdown in productivity growth. Labour productivity – the economic output produced per hour worked – has, for many decades, grown steadily at 2.3 per cent a year. All that changed in 2007, since when it has stubbornly flatlined.

Weak productivity growth is a problem everywhere, but the UK’s problem is among the worst in the developed world. Economists agree that the ultimate origin of productivity growth is innovation, so an obvious question to ask is whether our lack of productivity growth is related to the weakness of the UK’s research and development investment, in both the public and private sectors.

Productivity growth matters, because it is the fundamental driver behind increasing real incomes. If productivity growth doesn’t resume, living standards will continue to stagnate.

It matters for the Government’s finances, too. Current economic projections assume that productivity growth will soon start to bounce back. If it doesn’t, even accounting for all the austerity measures the Government plans, it will still not be possible to bring the deficit back under control. The political stakes, then, are high.

Slowing innovation

There are many theories for what underlies our productivity problem, and to distinguish between them requires more careful analysis.

Jonathan Haskel, at Imperial College, has shown that the problem isn’t one of the economy shifting to lower productivity sectors, nor is it about substituting labour for capital. Instead, it is a problem of what economists call ‘total factor productivity’ – that is, that part of economic growth that isn’t accounted for by increases in inputs of labour or capital.

In short, our productivity problem is indeed a problem of slowing innovation.

There are a couple of special factors that have affected the UK economy in the last decade that we need to be aware of.

The production of North Sea oil peaked in 1999; the oil and gas industry has been a major contributor to the UK’s economic growth, but as the oil runs out the productivity of that sector is inevitably falling.

Between 2000 and 2008, the productivity of the financial services sector rapidly rose. This rise went into reverse in the aftermath of the financial crisis, which revealed that much of the apparent profitability of the banking sector arose as a result of the implicit guarantees given by the tax-payer to underwrite its increasing appetite for risk. In the stricter post-crisis regulatory environment, productivity growth in this sector will (and should) remain subdued.

Declining North Sea oil and the continuing effects of the financial crisis on the financial services industry provide an ongoing headwind to productivity growth. This means that productivity in other sectors will have to grow even faster to compensate, if our economy is to return to health.

Improving research and development

Innovation in the sense used by economists, in the context of ‘total factor productivity’, encompasses much more than just the development of new products and improved processes through formal research and development. It includes learning-by-doing, adoption of best practices from elsewhere, user-inspired innovation and social innovation.

But R&D remains important, and Haskel’s work quantifies the contribution an increase in R&D could make to the economy’s overall productivity growth, which is material.

We need to be conscious that the R&D intensity of the UK economy has been declining for decades; we have gone in thirty years from being one of the most R&D intensive economies in the world to one of the least, having been surpassed on that measure first by Korea, and more recently China. The consequences of this decline have now come home to roost.

A solution to our productivity problem must involve an improvement in our overall R&D performance. This needs to involve both the public and private sectors; stagnating business R&D has been a major part of the UK’s problem, and the fact that more than half of that business R&D is funded from abroad means that it is very sensitive to the state of the publicly funded research base.

Given how critical our productivity problem is, it should be unthinkable to be reducing the public resources going into R&D now. Instead, we should be using the excellent research base we have in the UK’s universities, which has already demonstrated its willingness and ability to work with the private sector for the benefit of our wider economy and society, to rebuild our innovation economy.

This effort needs to balance the continuing need for long-term discovery science to secure our future, with some serious and focused efforts to develop the new technologies we know we need, in areas such as affordable low carbon energy and new healthcare technologies for an ageing population, and continuing work to unlock the economic benefits of research.

The alternative course, of continuing on our current path of stagnating productivity and stagnating innovation, isn’t inevitable. It would be a choice, a costly choice for the whole country, and it’s a choice we shouldn’t make.

The postgraduate support scheme projects show clearly that financial support can encourage students from diverse backgrounds, that employers are willing to engage in the process, and that curriculum innovation is possible. But, just as clearly, they show that finance is not the only challenge.